Our tendEncy to mentally allocate money for specific purposes can have a negative effect on our finances. In the conclusion of our 3 part series, we will examine the decades-old preference for retirees to hold on to their assets rather than experience the joy of spending their money on new experiences in retirement.
In our previous articles addressing retirement blind spots, we discussed how two behavioral biases—planning fallacy and anchoring bias—can influence critical financial decisions we make around retirement planning. This article discusses a third behavioral bias you need to be aware of that can trip up your best intentions, mental accounting.
What is Mental Accounting?
Behavioral economist and Nobel Prize winner, Richard Thaler, introduced the mental accounting bias in 1999. He explained the concept this way:
"Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.1"
In other words, most people mentally divide their assets into buckets allocated for specific purposes instead of one big pile of money. The mind divides money into three buckets. For example, when someone gets a paycheck, they'll likely set some aside for a future expense like a "rainy day" fund or a down payment on a house. Then, they use another portion to pay for their everyday needs, like groceries or entertainment. Lastly, they have a bucket of "future income" money for college or retirement.
Sounds logical, right? But here's an example of how mental accounting can have a negative effect. Some people dutifully contribute money every month to a low-interest-bearing savings account while at the same time racking up a large credit card balance and making monthly payments at a high-interest rate. That is a blind spot.
The Conundrum of Retirement Spending
Let's look at how people spend their accumulated savings in retirement and how mental accounting can work against their best interests.
For decades, conventional retirement planning has followed the simple concept that you should save money throughout your working years so that when you retire, you will have acquired enough to sustain you and your spending needs as long as you live. Of course, retirement planning is based on many assumptions of how long you will live and how much you will spend to support your lifestyle. But the basic premise has always been that you will spend down your assets throughout retirement,
But what we find is that retirees generally prefer to spend income over spending assets. They tend to hold on to their assets and want to preserve them. Have you ever heard a retiree say, "I only spend what my retirement investments earn. I live off my income." What we see is a pervasive mindset for people in retirement, and research supports this spending preference, as only 25% of retirees feel they will have to spend down principal2. Here's why:
"Retirees prefer to keep their assets untouched. Very few want to tap into their savings to finance their spending in retirement, especially those with high levels of assets who are very content to leave all or a significant amount of savings unspent. For most, retirement is not a time to live it up; it is more important to feel financially secure.2"
Again, you can see mental accounting at play here. Retirees tend to view the money they had accumulated as "untouchable" when it was actually designed to be spent in retirement. And while the desire to conserve and not overspend is admirable, retirees may miss the joy of spending freely on new experiences or charitable causes.
Don't overthink the Mental Accounting Bias
A good strategy to counter the effects of mental accounting is to treat money as having the same value and importance, regardless of how it is being used. You can then allocate money to accounts for daily expenses, discretionary spending, or savings and then weigh the importance of each account as to how much money you will apply.
And for retirement, building a plan and investment portfolio designed to generate cash flow may be another effective way to mitigate this bias since spending income (rather than assets) is preferred by so many retirees. You may want to consider different investment choices and products specifically created to produce predictable income that can't be outlived.
We hope you have found this series on behavioral biases helpful, and we encourage you to discuss what you've learned with your financial professional, who can be a valuable ally in helping you avoid these retirement blind spots.